Why A Low Payout Ratio Is Important

The payout ratio is an important metric to consider when analyzing a company and whether you would like to commit money to a position. Per Investopedia, the payout ratio can be defined as:

The amount of earnings paid out in dividends to shareholders. Investors can use the payout ratio to determine what companies are doing with their earnings.

Calculated as:

This sums it up pretty effectively. The payout ratio is basically a percentage of earnings paid out to investors in the form of dividends. A higher payout ratio means a company is paying out a higher percentage of their earnings to shareholders, while a lower payout ratio means a company is retaining a larger percentage of earnings to reinvest or grow the business.

There are two camps on this. Growth investors, who like to make their money from capital gains, usually like to see very low payout ratios or no dividends at all. They usually like to invest in a company that is experiencing blistering growth and continues to reinvest earnings back into the company to fuel that growth. Companies like Apple (AAPL) and Netflix (NFLX) would fit this camp well. Dividend investors, or income investors, typically like to receive a percentage of a company’s earnings in the form of dividends so that they can either reinvest those dividends as they see fit or cash out those dividends and pay bills with them. Companies like Procter & Gamble (PG) and PepsiCo (PEP) fit into this category. It’s the choice and flexibility that dividends provide me that I really enjoy. Also, as someone who plans to retire early in life, I would prefer to have steady and consistent income with which to fund my lifestyle.

One of my entry criteria is that I like to invest in a company with a payout ratio of 50% or less. I believe that a low, or moderate, payout ratio leaves room for further dividend growth. The growth of the dividend is also one of my entry criteria, and is a cornerstone of my investment philosophy. I think with a payout ratio of around 50% you are getting the best of both worlds. You get the income, in the form of dividends, and you also get the growth from the retained/reinvested earnings that the company doesn’t pay out to you. If a company is consistently paying out most of their earnings directly to shareholders it doesn’t leave a lot on the table to grow the company and keep up that high payout ratio. What can I say? I like to have my cake and eat it too!

I think a 50% payout ratio is really a sweet spot for most dividend growth stocks. I think lower is also great, as that leaves a lot of room in the tank for large dividend increases in the future. Too low, however, and you get the sense that the company may not have a culture of being shareholder friendly. 50% of the earnings of a lot of blue chip dividend growth stocks is still a lot of money, and it leaves a lot on the table to reinvest in the company and keep the growth moving in an upward direction.

I like to look at Net Cash Flow as my very first screen. Net cash flow is important because it tells an investor how much cash a company is generating from operations. Earnings can be manipulated and has non-cash charges that have no effect on the ability to pay dividends. I have written an article on this subject for anyone interested at:http://blog.arborinvestmentplanner.com/2011/05/what-is-net-cash-flow

FCF is also a metric I use. Obviously, that’s digging a little deeper into a company’s statements. Earnings can be manipulated…this is true. But one-time events can also have dramatic impacts on FCF too. It’s always good to look at the overall picture, of which EPS payout ratios and FCF payout ratios are both part of.

Great points. I agree that cash flow is important, as dividends come from cash..unless they’re coming from debt which is something we would all stay away from. Earnings can be manipulated, but as I said in my last comment I also believe that one-time events can have negative impacts on cash flow. In the end, you have to look at everything in front of you and make a decision. Generally, I like to compare apples to apples, and when you’re comparing EPS payout ratios from company to company you can generally get a feel for who’s keeping things under control.

Thanks for stopping by. I appreciate your additions. I agree that an EPS payout ratio is not the end-all be-all of payout ratio metrics.

I’m bullish on T, and have been close to pulling the trigger a few times now. It’s very high on the watch list right now. I’ve written about it a few times, and it was on my top three for buys last month. I picked AFL instead.

Payout Ratio is one of things I look at for new investments (as I’ve mentioned before, I take more risks than you would be comfortable with, but thats because I have to play catch up), though I look at 60% as the ceiling.

Disclosure here, I work for the company I am about to mention, but since you mentioned AT&T I thought I’d mention TELUS, which is one of Canada’s biggest telecoms. They have a Payout Ratio of about 61%, but they’ve also committed to 10% dividend increases every year for the next two years (and just recently increased it, so that would total a three year increase commitment). I invest in Verizon in the US and TELUS (since I work there and can participate in the stock purchase plan) as I think telecom is a great sector to be in, and want to be in the bigger players in both countries. The reason I mention TELUS is they do trade on the NYSE under the TU ticker, so if you’re looking at Telecom exposure, while AT&T is a great option for the US (and I believe you have the Spanish telecom as well, so there’s your foreign exposure), TELUS might be worth looking at as well, though the yield right now is 4.6% (not bad at all, but not as juicy as AT&T)

Well you already know how I feel about the dividend payout ratio, since I’ve written on it to the Nth degree – as low as possible with a good dividend yield 40% to 60% is ideal, and a yield over 3%. I feel that once the dividend yield gets over 6% (and the DPR gets higher as well) a stock becomes risky.

Funny you mention Telus, becuase you are bang on! I have an article written for DSO (Dividend Stocks Online), and it will be published soon. I compared the big Canadian Telecoms that trade on the NYSE, and Telus is the best of the Canadian Telecoms (as compared to Rogers, Bell and Shaw).

I used to think like you Mantra. But then I found this: “The historical evidence strongly suggests that expected future earnings growth is fastest when current payout ratios are high and slowest when payout ratios are low”

Telus isn’t a household name here in America, and I haven’t looked into the company before. It does have a solid, and growing, dividend. I’ll have to research this one further as part of my telecom watch list. I do like telecoms for current income. Telus has a pretty solid yield, and it’s growing too.

I absolutely agree. High yield usually equals high risk. Anytime you have high yield you have to do your homework. I would agree that a ratio of 40%-60% is ideal, with 50% being right in that “sweet spot”.

You have to find an investment strategy that works for you. That’s the most important thing. Whenever you make an investment, you have to be comfortable with it. I feel most comfortable with a yield over 3% and a pretty conservative payout ratio of around 50%. Obviously some investments fall outside these lines, and some companies have rough quarters/years where the numbers will become skewed. That’s why it should always be “buy and monitor” not buy and hold.

Thanx D Mantra for a good primer on this important metric. Good article for both experienced investors but also easy to understand for novices. Agree that it needs to be looked at as part of the total picture along w/ FCF ratio.

I’ve written before that T is a good choice but I already have a large position. I also have TEF and TU (Telus). I recently considered many of the same choices u did and it came down to INTC or PEP. Close but I pulled the trigger on PEP @ $60. Now I’m looking at an insurance stock. Know u bought AFL. Plus D Monk just wrote an analysis. I’ll have to check it out. I’m also considering SLF, a Canadian company focused on life insurance.

@D Ninja and New Grufti, As Canadians, any thoughts on SLF? Also great you guys mentioned TU. Sometimes I feel like I’m the only American who’s heard of them and own the stock. A bit bummed though I think the American shares are non-voting.

@D Ninja, Great website. Like it ALMOST as much as D Mantra’s.

PS. Sorry, I still don’t have a Google account so I’ll sign my “handle” for now so u know who the offender is.

@Rock the Casbah: I think Sun Life is pretty solid. It’s the insurer of choice for a lot of major Canadian corporations (the aforementioned TELUS for one, RBC for another, I worked for both companies so had experience dealing with them). I do wonder if the dividend is sustainable though, given how exposed they are in terms of the international markets. Sun Life did recently divest its life reinsurance business which I think is a solid move. I haven’t invested in any insurers (personally) because in Canada so many of them are primarily exposed to international market forces as Canada represents a solid, but smaller, slice of their business.

That said, Sun Life has hit also strikes me as oversold right now, and it’s dividend yield is somewhere north of 6% as a result. Getting in now at this price would give a bit of a cushion if they are forced to hold the dividend steady or worse, slice into it. The P/E is also somewhere around 7-8 at the current price as well, so while I’m not gung ho on any of the insurance/financial services companies at the moment, they are becoming more interesting to me as the crisis goes on.

Thanx Neu Grufti for the input. I’m interested in SLF because it looks attractively valued relative to earnings, pays a fat divvy that looks sustainable based on payout ratio and has a reasonable Amt of long term debt. As u stated, I did hear they had significant exposure in Asia. It’s trading at it’s 52 week low and I don’t think there can be much more momentum to move lower. W/ good reason, many are nervous about the financial sector now but when that happens Warren Buffet’s “be greedy when others fearful” adage comes to mind.

U and D Ninja mentioned Canadian telecoms and TU in particular. I heard Harper was considering opening up Canada’s Telecomm market up more to international companies. Any thoughts on how that could impact telecomm stocks? As always, any input from North of the border is appreciated.

I agree T is a nice choice right now. I’ve been looking at some telecoms, including T, some defense companies (RTN and LMT) and adding to some consumer staples for my next purchase(s) (PEP, PG).

What’s your thoughts on TEF since you are a fellow shareholder? I’m concerned about their debt first and foremost, not their headquarters being in Spain. I think the business is strong and growing, but they seem to be addicted to debt. I wouldn’t mind a smaller dividend to keep the debt low. I wish I would have bought at current prices, as I feel it’s a good value…but don’t want to make this position too heavy due to the debt. Are you adding? How large is your TEF position if you don’t mind me asking?

Nice addition on PEP @ $60. I think that’s a pretty good long-term holding, and wouldn’t mind buying some more myself at these levels. It’s in the mix for my next purchase, that’s for sure. I also think having INTC in the mix isn’t a bad idea. I’m leery on tech, but this will be my one tech holding.

Thanks again for the compliments and I’m really glad you enjoy the site.

RE: TEF I also am concerned by their debt. I think u once described it as your riskest stock. In so far as I think u meant at most risk of cutting it’s divvy then I also agree it’s the most riskiest position in my portfolio. For that reason, it’s my smallest position @ about 2-3% and I will have NO plans to add any more.

However, their Latin American operations offer great growth opportunties and are currently more than offsetting their losses in Spain. Their management is divvy friendly committing to forthcoming increases. Normally this is a good thing but here I question it. I can’t help thinking that given their already very hi yield and debt it would be more prudent for them to use more FCF to pay down debt for now rather than increase the divvy. Their FCF payout ratio has been steadily increasing and at this rate they’ll have little left to pay debt and be forced to roll it over at potentially higher interest rates. Granted, telecomm’s do carry higher debt but TEF’s is higher than it should be.

Guess that’s the risk for an extra fat divvy and hot growth prospects.

I haven’t really checked out VOD but it seems to get slot of good virtual ink from divvy bloggers.

I agree that the risk with TEF is for the large dividend and growth prospects. I also agree that the more prudent move would be to reduce debt instead of increasing the dividend. The dividend is already fairly large, and continuing to roll over the debt is not a good long-term solution.

We’ll have to see how it goes. Again, I’d love to average down as I feel it’s a good value at current prices (even with a dividend cut), but it’s just too large a position already, unfortunately.

I’ll join the bandwagon in favor of a payout ratio between 40%-60%. For me to consider a company with a ratio over 60% it needs to demonstrate a lot of stability in terms of earnings and dividend increases as it has less margin for error if earnings take a big hit. Do you have a minimum payout ratio that you look for? When I find a company paying out in the low 30%s with no demonstrated trend toward accelerating dividend increases so that they could break the 40% level I tend to shelve the idea.

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